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Quarterly Letter to Clients

October, 2006

Indices at quarter-end (September 30, 2006):

Dow Jones Industrials: 11,679.07 3Q'06 +4.74% YTD +8.99%

Standard & Poor's 500: 1,335.85 3Q'06 +5.17% YTD +7.02%

Are you feeling it at the pump? Oil prices have begun to come down. The reasons are probably as much psychological as they are tangible. Anytime a commodity—or a stock, or a service, for that matter—becomes too high priced, alternatives are found, or people find they can do without (or with less, anyway), demand slackens and finally prices begin to fall.

I know that we are only a bad news day away from higher oil prices. And those more cynical among us would say that the price decline corresponds with the upcoming election season. But whether it is psychological, or new supply coming on stream, or lessened demand due to price, or a combination of all of these things, cheaper gas is still welcome.

Several other industrial commodities have also begun to descend, notably gold, silver, and copper along with certain agricultural commodities. Perhaps soon we can look forward to the government releasing inflation figures without excluding food and fuel.

One way to read these signs is to infer that the economy is slowing. But another way is to surmise that prices had simply become unsustainably high, and came down because of their own weight. An argument could be made that both factors were at work.

Of course, at the same time that oil starts to fall, we have a break in the housing market. And also a break in interest rates. They’re not taking them down, but at least the Fed has finally stopped bumping them up. After 18 consecutive nudges to the upside, our nation’s central bankers have let it be known that they will finally leave rates alone—at least for awhile. Two meetings have now passed without any increase in rates, and speculation grows that the Fed might even reverse course and lower rates. I am not of that opinion.

If it appears like I’m avoiding the subject of the stock market, well, who can blame me? For the six years from the beginning of 2000 to the end of 2005 both the Dow Jones and the S&P 500 have returned, on average, negative results. And that includes the stellar performance that we saw in 2003. Not exactly inspirational reading, and even less thrilling to write about.

Bonds were a much better place to be, showing returns, over that same time period, in the upper single-digits. Indeed, over the last twenty years bond returns have been competitive with stocks. But that game is almost certainly over.

If you were invested in the current rage--hedge funds--you are probably not feeling so ebullient just now. The problems at Amaranth mirror what happened at Long Term Capital Management less than a decade ago. Keep in mind the ancient axiom that if returns seem too good to be true, they probably are.

In short, for several years now there has been no prudent way to generate the returns that we came to love in the previous decade.

Stocks made a run at their all-time highs again at the end of September, and the major equity averages have not done badly at all this year. Still, it seems a subdued market, and it feels like you have to scrape and claw for single-digit gains.

I feel fortunate to have been able to post decent returns in stocks and in bonds for the year-to-date. And I feel confident that stocks will prove rewarding going forward. Rational thinking seems to have returned to the markets—at least temporarily.

Jim Pappas